FINRA Series 6 Investment Company and Variable Contracts Products Representative ExaminationProcessing Customer Orders and TransactionsMedium
A registered representative learns that a client, aged 62, who purchased a variable annuity contract five years ago, decides to surrender the contract entirely. The client originally invested $100,000, and the current contract value is $120,000. What is the tax implication for the client upon surrender?
- ANo tax is due since the client is over 59½.
- BThe entire $120,000 is subject to ordinary income tax.
- CThe $20,000 gain is subject to ordinary income tax.
- DThe $20,000 gain is subject to capital gains tax.
Show answer & explanationAnswer & explanation
Correct answer: C. The $20,000 gain is subject to ordinary income tax.
When a variable annuity is surrendered, any amount received above the cost basis (premiums paid) is considered ordinary income and is taxable. In this case, the gain is $120,000 (current value) - $100,000 (cost basis) = $20,000. Since the client is over 59½, the 10% penalty for early withdrawal does not apply, but the gain is still taxed as ordinary income.
Why the other options are wrong
- A. While the 10% penalty is waived, the gain itself is still subject to ordinary income tax.
- B. Only the gain is taxable, not the return of principal.
- D. Gains from variable annuities are taxed as ordinary income, not capital gains.
Variable Annuity Surrender Taxation (Over 59½)
Upon surrender of a variable annuity, any gain above the cost basis is taxed as ordinary income, but the 10% early withdrawal penalty is waived if the owner is over 59½.
- LIFO (Last-In, First-Out) tax treatment.
- Gains are taxed as ordinary income.
- No 10% penalty if over 59½.
Memory trick: Gain is income, age saves the fine.